“People are our greatest asset.”
This phrase has been recited so often by businesses it has acquired a French flavor: it’s a cliché that’s passé. Cynical business consultants write articles that begin “Stop Telling Me People Are Your Greatest Asset.”
And yet…it’s true. Especially for small businesses.
The efforts and skills of the people working in a business—the owners, the partners, the employees—are critical to its success; no amount of automation or systems management can replace essential human capital.
If people are the most important assets in a business, losing them also presents its greatest risk. Businesses can manage this risk in several ways. To protect the business from losing a key person to a competitor, it may offer attractive compensation and benefit packages, provide paths to ownership, or insist on non-compete agreements. And in the event of a disability or death, the business can obtain insurance to protect its financial interests.
Particularly in small businesses, where a few individuals can have an outsized impact on the company’s overall health, key person insurance should be a primary consideration.
Defining Key Persons
While every person working in a business can be a great asset, not all are so critical they should be insured; some vacancies can be easily replaced. The emphasis is on insuring key producers. Some criteria for defining key-person status:
• Which individuals have skills, knowledge or connections that would be difficult to replace? These could be partners, high-performing sales reps, or technical experts like engineers or programmers, whose absence would seriously impact business.
• Does the company’s operation depend on just a few people to generate a substantial portion of its income? “Rainmakers” who snare big clients, or reps who are responsible for the majority of sales, fit this category.
• Does the business carry debt that would have to be paid off if a key individual were to die or become disabled? Loans for many small businesses often require personal guarantees of the owners, and may be due in full if one is no longer active in the business.
• Is the business seeking additional capital or planning to go public? Banks or investment firms may refuse to lend or make an investment unless the business has key person coverage. And in the event of a public offering, key person coverage may be required for top executives and board members before a merger or IPO.
Key Person Life Insurance: A Brief Overview
When a business purchases key person life insurance on an important individual, the business is both the policy owner and beneficiary. The employee is the insured; under most circumstances, the employee does not receive any benefits from the policy.
Key person life insurance can be either a term or permanent policy. With term insurance, a benefit is paid to the business if the insured dies during the term. Besides a death benefit, permanent life insurance includes a cash value component.
A key person life insurance program offers several attractive benefits to the business.
• Control. In the event of a claim, the business, as owner of the policy, can use the proceeds however it wants. Funds can be used to hire and train new personnel, settle debts, smooth out cash flow as the business adjusts to the loss, or however else management deems beneficial.
• Cost Efficiency. If term insurance is selected, most businesses can achieve a high level of immediate protection at a very reasonable cost. If the business chooses a permanent policy with cash value, it is carried on the firm’s books as an asset because the company owns the policy. Cash values can be an attractive strategy for the business to accumulate long-term on a tax-deferred basis.*
• Security. The company’s standing with banks, creditors, and valued customers is enhanced because these parties know that in the event of the death of a key person, the business is positioned to continue uninterrupted.
• Flexibility. The company may change the purpose and function of a permanent life policy over time. In the policy’s early years, the death benefit may be primary. Over time, as cash values accumulate, other options may appear. For example, the policy could provide the funding for a Non-Qualified Deferred Compensation (NQDC) agreement in which the insured employee becomes either the owner of the policy or a recipient of a stream of income from the cash values.
In this context, there are many creative options where key person insurance not only protects against the physical loss of an important individual, but also insulates the business from losing this person to a competitor.
Moving From Idea to Implementation
Despite the clear advantages to securing key person insurance, it’s common for a business to let the idea slide. A recent survey of small businesses by the National Association of Insurance Commissioners revealed the following:
71% of respondents indicated they were very dependent on one or two key people for their success.
Only 22% of respondents indicated they have a key person life insurance policy in place.
This lack of implementation isn’t necessarily a result of negligence or disinterest on the part of ownership. Implementing a key person insurance program requires a knowledge of policy options, ownership arrangements, tax laws, and reporting requirements. Getting a plan in place may involve retaining the services of several financial professionals to make it happen.
* Dividends are not guaranteed. They are declared annually by the company’s board of directors.
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This article was prepared by an independent third party. Material discussed is meant for general informational purposes only and is not to be construed as tax, legal, or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon only when coordinated with individual professional advice.
Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS), 355 Lexington Avenue, 9 Fl., New York, NY 10017, 212-541-8800. Securities products and advisory services offered through PAS, member FINRA, SIPC. This firm is an agency of The Guardian Life Insurance Company of America® (Guardian), New York, NY. PAS is an indirect, wholly owned subsidiary of Guardian. Wealth Advisory Group LLC is not an affiliate or subsidiary of PAS or Guardian. Wealth Advisory Group LLC is not registered in any state or with the U.S. Securities and Exchange Commission as a Registered Investment Advisor. Neither Guardian, PAS, Wealth Advisory Group, their affiliates/subsidiaries, nor their representatives render tax or legal advice. Please consult your own independent CPA/accountant/tax adviser and/or your attorney for advice concerning your particular circumstances.
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Submitted by Elozor Preil